An increase in the stock market's overall performance, like the one that took place in October, can turn inexperienced investors into trade-happy amateurs, according to Brigham Young University business professors in a study published in The Review of Financial Studies.
"When investors start off in the market, they tend to trade pretty conservatively," said Steven Thorley, the H. Taylor Peery professor of finance at BYU's Marriott School of Management. "In periods where the overall stock market performs well, they see a good return on their portfolio and figure they are good at picking stocks, so they start to trade more frequently."
Thorley and co-researchers Keith Vorkink and Meir Statman tested the proposition that investors trade their stock more frequently after increases in the general market return cause them to have higher confidence in their stock picking abilities. Behavioral economists refer to these beliefs as "investor overconfidence" and "biased self-attribution." Vorkink is the Richard E. Cook associate professor of finance at the Marriott School, and Statman is the Glenn Klimek professor of finance at the Leavey School of Business at Santa Clara University.
With October's rise in the overall stock market, Thorley expects to see "an increasing interest in individuals trading in the market and measurable increases in trading volume as a result of investor overconfidence."
For their study, the trio examined trading volume – the amount of stock bought or sold monthly – on the New York Stock Exchange. They found that trading activity correlates with the stock market's recent increases or declines. When the market goes up, investors begin to trade more often, even though the realized returns often have little to do with their trading ability.
"There's an old saying on Wall Street: 'Don't confuse brains with a bull market,'" said Thorley. "Investors should not assume they are more talented than average just because the market's going up, but our empirical study suggests that's just what they do."
Terrance Odean, the Willis H. Booth Professor of Banking and Finance in Berkeley's Haas School of Business who helped develop the investor overconfidence theory, said, "In this important paper, Statman, Thorley and Vorkink establish a strong link between past market returns and contemporary trading volume. In so doing, they further our understanding of why individual investors trade so much, often to their detriment."
Vorkink notes one illuminating finding from the study: a really good monthly return in the market increases trading volume by the equivalent of an extra month of trading, spread out over the six following months.
"The market makers – the exchanges, dealers and brokers – celebrate bull markets, and not just because they probably have money in the market themselves. It means that business will pick up," said Thorley, explaining that a lot of those increases in trading commissions come at the expense of overconfident investors.
This type of investor ascribes positive outcomes to themselves and negative ones to forces outside their control, said Vorkink, an associate professor of business management.
"It's a case of biased self-attribution: bad luck, or 'something outside my control is to blame,' if the market goes down, good trading skills, or 'it was me,' if the market goes up," says Vorkink, explaining that the true measure of investors' skill is how much better their stocks do than the overall market.
Using a database from the Center for Research in Security Prices, the researchers looked for periods of excessive trading volume in three past decades. Then, they isolated all the logical reasons people should trade stock, such as rebalancing their retirement portfolios, diversification and cashing in. Even after accounting for those rational reasons why people should trade, and other behavioral reasons, they found that trading volume still fluctuated significantly from month to month and that prior market returns explained much of the variation in both market volume as well as individual security trading volume.
"The average investor should understand that the stock market is one of the most competitive professional arenas in the world," said Thorley, explaining that there are huge amounts of resources, expertise and time thrown at the problem of how to analyze and pick stocks that will outperform the market. "From a purely rational or strategic viewpoint, individuals shouldn't try to play this game, because the odds aren't in their favor."
Instead, investors should put their money in a well-diversified mutual fund, preferably an index fund or exchange traded fund that mirrors the market's natural rise and not trade so much, said Thorley.
"Because of the extra costs of active trading, including bid-ask spread, tax inefficiencies, and research time and cost, investors must be in the top third of all active traders in order to beat the market."